chapter 18

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International Economics, 10e (Krugman/Obstfeld/Melitz)
Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention
18.1 Why Study Fixed Exchange Rates?
1) Central banks often intervene in currency markets. This activity is called
A) managed floating.
B) fixing exchange rates.
C) currency warfare.
D) super-pegging.
E) flexible floating.
Answer: A
Page Ref: 495-497
Difficulty: Easy
2) Why is it important to understand fixed exchange rates in the modern global economy?
Answer: Fixed rates continue to be important for four reasons:
1. Managed floating: Central banks intervene in foreign exchange markets.
2. Regional currency arrangements: Some countries peg their currency to another currency.
3. Developing countries and countries in transition: These countries often attempt to peg their
currency to another currency.
4. Lessons of the past: Fixed exchange rates could have a resurgence.
Page Ref: 495-497
Difficulty: Moderate
3) Which of the following is an example of a regional currency arrangement?
A) exchange rate union
B) currency cartel associations
C) free-trade zones
D) most-favored nation status
E) agreement on commercial trade
Answer: A
Page Ref: 495-497
Difficulty: Easy
4) Industrialized countries typically ________ their floating exchange rates. Developing
countries often ________ their floating exchange rates.
A) manage; peg
B) peg; manage
C) allow markets to determine; fix
D) fix; manage
E) fix; allow markets to determine
Answer: A
Page Ref: 495-497
Difficulty: Easy
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18.2 Central Bank Intervention and the Money Supply
1) A central bank's international reserves consists of its holdings of
A) gold.
B) silver and gold.
C) foreign assets and gold.
D) domestic assets and precious metals.
E) foreign and domestic currency holdings.
Answer: C
Page Ref: 497-501
Difficulty: Easy
2) The liabilities side of a central bank's accounts consists of
A) deposits held by private banks.
B) currency in circulation.
C) deposits held by private banks and currency in circulation.
D) deposits held by foreign banks, domestic assets, and currency in circulation.
E) foreign assets and domestic assets.
Answer: C
Page Ref: 497-501
Difficulty: Easy
3) Which one of the following statements is most correct?
A) Any central bank purchase of assets automatically results in an increase in the domestic
money supply, while any central bank sale of assets automatically causes the money supply to
decline.
B) Any central bank purchase of assets results in an increase in the domestic money supply,
while any central bank sale of assets causes the money supply to decline.
C) Any central bank purchase of assets automatically results in a decrease in the domestic money
supply, while any central bank sale of assets automatically causes the money supply to decline.
D) Any central bank purchase of assets automatically results in a decrease in the domestic
money supply, while any central bank sale of assets automatically causes the money supply to
increase.
E) Any central bank purchase of assets automatically results in an increase in the domestic
money supply, while any central bank sale of assets does not necessarily affect the money
supply.
Answer: A
Page Ref: 497-501
Difficulty: Easy
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4) Which one of the following statements is the most correct?
A) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated increase in the home central bank's foreign asset implies an increased home
money supply.
B) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated increase in the home central bank's foreign asset implies a decreased home money
supply.
C) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated increase in the home central bank's foreign asset implies an increased home
money demand.
D) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated decrease in the home central bank's foreign asset implies an increased home
money supply.
E) If central banks are not sterilizing and the home country has a balance of payments shortage,
any associated decrease in the home central bank's foreign asset implies an increased home
money supply.
Answer: A
Page Ref: 497-501
Difficulty: Easy
5) Which one of the following statements is most correct?
A) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated increase in a foreign central bank's claims on the home country implies a
decreased foreign money supply.
B) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated decrease in a foreign central bank's claims on the home country implies a
decreased foreign money demand.
C) If central banks are not sterilizing and the home country has a balance of payments surplus,
any associated decrease in a foreign central bank's claims on the home country implies a
decreased foreign money supply.
D) If central banks are not sterilizing and the home country has a balance of payments shortage,
any associated decrease in a foreign central bank's claims on the home country implies a
decreased foreign money supply.
E) If central banks are not sterilizing and the home country has a balance of payments shortage,
any associated decrease in a foreign central bank's claims on the home country implies an
increased domestic money supply.
Answer: C
Page Ref: 497-501
Difficulty: Easy
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6) A balance sheet for the central bank of Pecunia is shown below:
Central Bank Balance Sheet
Assets
Foreign assets
$1,000
Domestic assets
$1,500
Liabilities
Deposits held by private banks
Currency in circulation
$500
$2,000
Please write the new balance sheet if the bank sells $100 worth of foreign bonds for domestic
currency.
Answer: Central Bank Balance Sheet
Assets
Liabilities
Foreign assets
$900
Deposits held by private banks
$500
Domestic assets
$1,500
Currency in circulation
$1,900
Page Ref: 497-501
Difficulty: Easy
7) A balance sheet for the central bank of Pecunia is shown below:
Central Bank Balance Sheet
Assets
Foreign assets
$1,000
Domestic assets
$1,500
Liabilities
Deposits held by private banks
Currency in circulation
$500
$2,000
Please write the new balance sheet if the bank purchased $100 in foreign bonds by writing a
check on itself.
Answer: Central Bank Balance Sheet
Assets
Liabilities
Foreign assets
$1,100
Deposits held by private banks
$600
Domestic assets
$1,500
Currency in circulation
$2,000
Page Ref: 497-501
Difficulty: Moderate
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8) A balance sheet for the central bank of Pecunia is shown below:
Central Bank Balance Sheet
Assets
Foreign assets
$1,000
Domestic assets
$1,500
Liabilities
Deposits held by private banks
Currency in circulation
$500
$2,000
Please write the new balance sheet if the bank makes a sterilized transaction by selling $100 of
foreign assets for domestic currency and then purchasing $100 of domestic assets by writing a
check on itself.
Answer: Central Bank Balance Sheet
Assets
Liabilities
Foreign assets
$900
Deposits held by private banks
$600
Domestic assets
$1,600
Currency in circulation
$1,900
Page Ref: 497-501
Difficulty: Moderate
9) Please define and give an example of sterilized foreign exchange intervention.
Answer: Sterilized foreign exchange intervention occurs when a central bank carries out equal
foreign and domestic asset transactions in opposite directions to nullify the impact on the
domestic money supply. An example is a central bank purchasing $100 of domestic assets but
selling $100 of foreign bonds.
Page Ref: 497-501
Difficulty: Moderate
10) If the central bank does not purchase foreign assets when output increases but instead holds
the money stock constant, can it still keep the exchange rate fixed at ? Please explain.
Answer: No, the rise in output leads to an excess demand for money. If the central bank does not
increase supply to meet this demand, the domestic interest rate would rise above the foreign rate,
R*. This higher rate of return (and given expectations in the foreign exchange market) would
cause the exchange rate to fall below .
Page Ref: 497-501
Difficulty: Difficult
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11) If the central bank does not purchase foreign assets when output increases but instead holds
the money stock constant, can it still keep the exchange rate fixed at ? Please explain with the
aid of a figure.
Answer:
No, the rise in output leads to an excess demand for money. If the central bank does not increase
supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This
higher rate of return (and given expectations in the foreign exchange market) would cause the
exchange rate to fall below .
Page Ref: 497-501
Difficulty: Moderate
18.3 How the Central Bank Fixes the Exchange Rate
1) A system of managed floating exchange rates is
A) a system in which governments may attempt to moderate exchange rate movements without
keeping exchange rates rigidly fixed.
B) a system in which governments use flexible exchange rates.
C) a system in which governments are forbidden from attempt to moderate exchange rate
movements without keeping exchange rates rigidly fixed.
D) a system in which governments need to reach a prior agreement among them before they may
attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed.
E) a system in which governments use extensive fiscal policy to discourage exchange rate
movements.
Answer: A
Page Ref: 501-504
Difficulty: Easy
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2) Under fixed exchange rate, in general
A) the domestic and foreign interest rates are equal, R = R .
B) R = R + (Ee - E)/E.
C) the foreign and domestic interest rates are unequal.
D) the expected rate of domestic currency depreciation is high.
E) the expected rate of currency depreciation is one.
Answer: A
Page Ref: 501-504
Difficulty: Easy
3) Under fixed exchange rate, in general which one of the following statements is the MOST
accurate?
A) The following condition should hold for domestic money market equilibrium: Ms/P = L(R ,
Y).
B) The following condition should hold for domestic money market equilibrium: Md/P = L(R ,
Y).
C) The following condition should hold for domestic money market equilibrium: Ms = L(R , Y).
D) The following condition should hold for domestic money market equilibrium: P = L(R , Y).
E) The following condition should hold for domestic money market equilibrium: R*Md/P =
L(Y).
Answer: A
Page Ref: 501-504
Difficulty: Easy
4) Which one of the following statements is the MOST accurate?
A) Under a fixed exchange rate, central bank monetary tools are powerless to affect the
economy's money supply.
B) Under a flexible exchange rate, central bank monetary tools are powerless to affect the
economy's money supply or its output.
C) Under a fixed exchange rate, fiscal policy tools are powerless to affect the economy's money
supply or its output.
D) Under a fixed exchange rate, central bank monetary tools are powerless to affect the
economy's money supply or its output.
E) Under a dirty float exchange rate, central bank monetary tools are powerless to affect the
economy's money supply or its output.
Answer: D
Page Ref: 501-504
Difficulty: Easy
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5) What is the expected dollar rate of return on dollar deposits if today's exchange rate is $1.10
per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10%,
and the euro interest rate is 5%?
A) 10%
B) 11%
C) -1%
D) 0%
E) 5%
Answer: A
Page Ref: 501-504
Difficulty: Easy
6) What are the factors affecting the demand for foreign currency?
Answer: Three factors affect the demand for foreign currency. They are expected return, risk,
and liquidity.
Page Ref: 501-504
Difficulty: Moderate
7) Explain risk and liquidity of assets.
Answer: Risk is the variability an asset contributes to a savers' wealth. An asset's real return can
be unpredictable and savers dislike this uncertainty if the return fluctuates widely. Liquidity
refers to the ease with which an asset can be sold or exchanged for goods. Cash is the most liquid
of assets because it is always acceptable at face value as payment for goods or other assets. Thus,
savers consider an asset's liquidity and its expected return and risk in deciding how much of it to
hold.
Page Ref: 501-504
Difficulty: Moderate
18.4 Stabilization Policies with a Fixed Exchange Rate
1) By fixing the exchange rate, the central bank gives up its ability to
A) adjust taxes.
B) increase government spending.
C) influence the economy through fiscal policy.
D) depreciate the domestic currency.
E) influence the economy through monetary policy.
Answer: E
Page Ref: 504-509
Difficulty: Easy
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2) Fiscal expansion under fixed exchange rates will have what temporary effect?
A) the money supply will decrease.
B) output will decrease.
C) the exchange rate will increase.
D) the exchange rate will decrease.
E) there will be no effect.
Answer: D
Page Ref: 504-509
Difficulty: Easy
3) When a country's currency is devalued
A) output decreases.
B) output increases and the money supply decreases.
C) the money supply decreases.
D) output decreases and the money supply increases.
E) both the output and the money supply increases.
Answer: E
Page Ref: 504-509
Difficulty: Easy
4) Under fixed rates, which one of the following statements is the MOST accurate?
A) Monetary policy can affect only output.
B) Monetary policy can affect only employment.
C) Monetary policy can affect only international reserves.
D) Monetary policy can not affect international reserves.
E) Monetary policy can only affect money supply.
Answer: C
Page Ref: 504-509
Difficulty: Easy
5) Under fixed rates, which one of the following statements is the MOST accurate?
A) Fiscal policy can affect output, employment and international reserves at the same time.
B) Fiscal policy can affect only employment.
C) Fiscal policy can affect only international reserves.
D) Fiscal policy can affect only output and employment.
E) Fiscal employment can affect only output and international reserves.
Answer: A
Page Ref: 504-509
Difficulty: Easy
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6) Which one of the following statements is the MOST accurate?
A) Fiscal policy has the same effect on employment under fixed and flexible exchange rate
regimes.
B) Fiscal policy affects employment less under fixed than under flexible exchange rate regimes.
C) Fiscal policy affects employment more under fixed than under flexible exchange rate regimes.
D) Fiscal policy cannot affect employment under fixed exchange rate but does affect output
under flexible exchange rate regimes.
E) Fiscal policy can affect employment under fixed exchange rate regimes, but does not affect
output under flexible exchange rate regimes.
Answer: C
Page Ref: 504-509
Difficulty: Easy
7) Which one of the following statements is the MOST accurate?
A) Fiscal policy has the same effect on output under fixed and flexible exchange rate regimes.
B) Fiscal policy affects output more under fixed than under flexible exchange rate regimes.
C) Fiscal policy affects output less under fixed than under flexible exchange rate regimes.
D) Fiscal policy cannot affect output under fixed exchange rate but does affect output under
flexible exchange rate regimes.
E) Fiscal policy can affect output under fixed exchange rate but does not affect output under
flexible exchange rate regimes.
Answer: B
Page Ref: 504-509
Difficulty: Easy
8) Which one of the following statements is the MOST accurate?
A) A devaluation occurs when the central bank lowers the domestic currency price of foreign
currency, E, and a revaluation occurs when the central bank raises E.
B) A devaluation occurs when the central bank raises the domestic currency price of foreign
currency, E, and a revaluation occurs when the central bank lowers E.
C) Devaluation occurs when the domestic currency price of foreign currency, E, raises and a
revaluation occurs when E is lowered.
D) A devaluation occurs when the central bank of the foreign country raises the domestic
currency price of foreign currency, E, and a revaluation occurs when the central bank of the
foreign country lowers E.
E) A devaluation occurs when the central bank raises the foreign currency price of domestic
currency, E, and a revaluation occurs when the central bank lowers E.
Answer: B
Page Ref: 504-509
Difficulty: Easy
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9) Which one of the following statements is the MOST accurate?
A) Depreciation is a rise in E when the exchange rate is fixed while devaluation is a rise in E
when the exchange rate floats.
B) Depreciation is a decrease in E when the exchange rate floats while devaluation is a rise in E
when the exchange rate is fixed.
C) Depreciation is a rise in E when the exchange rate floats while devaluation is a rise in E when
the exchange rate is fixed.
D) Depreciation is a rise in E when the exchange rate floats while devaluation is a decrease in E
when the exchange rate is fixed.
E) Depreciation is a fall in E when the exchange rate is fixed while devaluation is a fall in E
when the exchange rate floats.
Answer: C
Page Ref: 504-509
Difficulty: Easy
10) Which one of the following statements is the MOST accurate?
A) Appreciation is a rise in E when the exchange rate floats while revaluation is a fall in E when
the exchange rate is fixed.
B) Appreciation is a fall in E when the exchange rate floats while revaluation is a fall in E when
the exchange rate is fixed.
C) Appreciation is a fall in E when the exchange rate is fixed while revaluation is a fall in E
when the exchange rate is flexible.
D) Appreciation is a fall in E when the exchange rate floats while revaluation is a rise in E when
the exchange rate is fixed.
E) Appreciation is a rise in E when the exchange rate floats while revaluation is a rise in E when
the exchange rate is fixed.
Answer: B
Page Ref: 504-509
Difficulty: Easy
11) Which one of the following statements is the MOST accurate?
A) Devaluation reflects a deliberate government decision.
B) Depreciation reflects a deliberate government decision.
C) Devaluation reflects a deliberate government decision while depreciation is an outcome of
government actions and market forces acting together.
D) Depreciation reflects a deliberate government decision while devaluation is an outcome of
government actions and market forces acting together.
E) Devaluation and depreciation have the same meaning and the same causes.
Answer: C
Page Ref: 504-509
Difficulty: Easy
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12) Which one of the following statements is the MOST accurate?
A) Revaluation reflects an outcome of government actions and market forces acting together
while appreciation reflects a deliberate government decision.
B) Revaluation reflects a deliberate government decision while appreciation is an outcome of
government actions and market forces acting together.
C) Revaluation reflects a deliberate government decision while appreciation is an outcome of
government actions.
D) Revaluation and appreciation have the same meaning and the same causes.
E) Appreciation reflects a deliberate government decision while revaluation is an outcome of
government actions and market forces acting together.
Answer: B
Page Ref: 504-509
Difficulty: Easy
13) Under fixed exchange rates, which one of the following statements is the MOST accurate?
A) Devaluation causes a decrease in output, a decrease in official reserves, and a contraction of
the money supply.
B) Devaluation causes a rise in output, a rise in official reserves, and an expansion of the money
supply.
C) Devaluation causes a rise in output and a rise in official reserves.
D) Devaluation causes a rise in output and an expansion of the money supply.
E) Devaluation causes a rise in official reserves, and an expansion of the money supply.
Answer: B
Page Ref: 504-509
Difficulty: Easy
14) Under fixed exchange rates, which one of the following statements is the MOST accurate?
A) Devaluation causes a rise in output.
B) Devaluation causes a decrease in output.
C) Devaluation has no effect on output.
D) Devaluation causes a rise in output and a decrease in official reserves.
E) Devaluation causes a decrease in output and in official reserves.
Answer: A
Page Ref: 504-509
Difficulty: Easy
15) Under fixed exchange rates, which one of the following statements is the MOST accurate?
A) Devaluation causes a reduction of the money supply.
B) Devaluation has no effect on the stock of money.
C) Devaluation causes an expansion of the money supply.
D) Devaluation causes a reduction in output.
E) Devaluation causes a reduction in official reserves.
Answer: C
Page Ref: 504-509
Difficulty: Easy
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16) The main reason(s) why governments sometimes chose to devalue their currencies is (are)
A) devaluation makes domestic goods more expensive in relation to foreign goods.
B) devaluation makes domestic services more expensive in relation to foreign services.
C) devaluation increases foreign reserves held by the central bank.
D) devaluation improves the current account and increases foreign reserves held by the central
bank.
E) devaluation hurts foreign currencies.
Answer: D
Page Ref: 504-509
Difficulty: Easy
17) Please draw a figure illustrating the actions the central bank must take to maintain a fixed
exchange rate following an increase in output.
Answer:
A rise in output from
to
will increase the real money demand, so the central bank must
purchase foreign assets and raise the money supply from
to , in order to maintain a fixed
exchange rate .
Page Ref: 504-509
Difficulty: Difficult
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18.5 Balance of Payments Crises and Capital Flight
1) A balance of payments crisis is best described as
A) a sharp change in interest rates sparked by a change in expectations about the level of
imports.
B) a sharp change in foreign reserves sparked by a change in expectations about the future
exchange rate.
C) a sharp change in interest rates sparked by a change in expectations about the level of exports.
D) a sharp change in foreign reserves sparked by a change in expectations about the level of
imports.
E) a sharp change in foreign reserves sparked by a change in expectations about domestic
production.
Answer: B
Page Ref: 509-511
Difficulty: Easy
2) The expectation of future devaluation causes a balance of payments crisis marked by
A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate.
B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world
interest rate.
C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate.
D) a sharp rise in reserves and an even greater rise in the home interest rate above the world
interest.
E) a sharp rise in reserves and a rise in the home interest rate to the level of the world interest.
Answer: C
Page Ref: 509-511
Difficulty: Easy
3) The expectation of future revaluation causes a balance of payments crisis marked by
A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate.
B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world
interest rate.
C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate.
D) a sharp rise in reserves and an even greater rise in the home interest rate above the world
interest.
E) a sharp fall in reserves and an unchanged home interest rate.
Answer: A
Page Ref: 509-511
Difficulty: Easy
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4) Capital flight
A) increases reserves.
B) is never associated with the expectation of devaluation.
C) may undo expected devaluation.
D) reduces losses during a devaluation scare.
E) decreases reserves and may induce devaluation.
Answer: E
Page Ref: 509-511
Difficulty: Easy
5) Currency crises may result from
A) central bank balance sheets with higher liabilities than assets.
B) political upheaval leading to lowering exports.
C) a reconfiguration of central bank balance sheets.
D) speculative attacks on the currency or central banks purchasing excessive amounts of
government bonds.
E) depreciation of foreign reserves.
Answer: D
Page Ref: 509-511
Difficulty: Easy
6) Which of the following best describes a deliberate government decision to lower the exchange
rate, E?
A) appreciation
B) depreciation
C) revaluation
D) devaluation
E) accumulation
Answer: C
Page Ref: 509-511
Difficulty: Easy
7) Please discuss the difference between the terms devaluation and depreciation.
Answer: Depreciation is a rise in the exchange rate E when the exchange rate floats, while
devaluation is a rise in E when the exchange rate is fixed. Devaluation reflects a deliberate
government decision, while depreciation is an outcome of government actions and market forces
("the invisible hand") acting together.
Page Ref: 509-511
Difficulty: Moderate
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8) Use a figure to illustrate the ineffectiveness of monetary policy to spur on an economy under a
fixed exchange rate.
Answer:
The initial equilibrium rests at point 1. If the central bank wishes to use monetary policy to
increase output from
to , then they might buy domestic assets and shift the AA curve
outward. However, the central bank must maintain a fixed exchange rate , so would have to
sell foreign assets for domestic currency, returning the economy to point 1.
Page Ref: 509-511
Difficulty: Difficult
9) Use a figure to explain the potential effectiveness of fiscal policy to spur on the economy
under a fixed exchange rate.
Answer:
With an aim toward increasing output, the government could use fiscal policy to shift the DD
curve outward. The central bank will have to take steps to maintain a fixed exchange rate ,
among the options is buying foreign assets with money, to shift the AA schedule outward until
the equilibrium at point 3 is reached.
Page Ref: 509-511
Difficulty: Difficult
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10) Define devaluation and use a figure to show the effect of a currency devaluation on the
economy.
Answer:
A devaluation occurs when the central bank raises the domestic currency price of foreign
currency. In the figure, the domestic currency is devalued from to . Since nothing in the DD
schedule has changed, the new equilibrium at point 2 must be reached by an expansion of the
money supply (AA curve shifts outward). Notice also that output has increased from
to .
Page Ref: 509-511
Difficulty: Difficult
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11) Please use a figure to discuss whether or not a devaluation under a fixed exchange rate has
the same long-run effect as a proportional increase in the money supply under a floating rate.
Answer:
A currency devaluation shifts the AA schedule outward from equilibrium point 1 to equilibrium
point 2. The devaluation does not change long-run demand or supply conditions in the output
market. Thus, the increase in the long-run price level will exactly offset the increase in exchange
rate. Thus, a devaluation is neutral in the long run and this is the exact same scenario as for an
increase in the money supply under a floating exchange rate.
Page Ref: 509-511
Difficulty: Difficult
18.6 Managed Floating and Sterilized Intervention
1) Imperfect asset substitutability assumes
A) the returns on foreign and domestic currency bonds are identical.
B) the returns on foreign and domestic currency are unrelated.
C) the risks of holding foreign and domestic currency are identical.
D) the risks of holding foreign and domestic currency are unrelated to returns.
E) the returns on foreign and domestic currency differ and are influenced by risk.
Answer: E
Page Ref: 512-517
Difficulty: Easy
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2) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc as
foreign currency flowed ________ the country. As result, Swiss products became ________
competitive in world markets.
A) depreciation; out of; more
B) depreciation; into; more
C) appreciation; out of; less
D) depreciation; out of; less
E) appreciation; into; less
Answer: E
Page Ref: 512-517
Difficulty: Easy
3) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc. In 2011,
the Swiss central bank intervened in order to cause a(n) ________ of the franc.
A) appreciation; appreciation
B) depreciation; depreciation
C) appreciation; revaluation
D) depreciation; appreciation
E) appreciation; depreciation
Answer: E
Page Ref: 512-517
Difficulty: Easy
4) Perfect asset substitutability is the assumption that
A) the foreign exchange market is in equilibrium only when expected returns on domestic assets
are greater than returns on foreign currency bonds.
B) the foreign exchange market is in equilibrium only when expected returns on foreign currency
bonds are greater than returns on domestic assets.
C) the foreign exchange market is in equilibrium only when expected returns on all assets are
negative.
D) the foreign exchange market is in equilibrium only when expected returns on domestic assets
are equal to returns on foreign currency bonds.
E) the foreign exchange market is in equilibrium only when domestic assets are risk-free.
Answer: D
Page Ref: 512-517
Difficulty: Easy
5) Imperfect asset substitutability exists
A) when it is possible for the expected returns on two assets to be different.
B) when the expected returns on two assets are the same.
C) only when one asset is foreign and the other is domestic.
D) when there is risk in the foreign exchange market.
E) when assets are liquid.
Answer: D
Page Ref: 512-517
Difficulty: Easy
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6) The interest parity condition can be written as
A) R = R - (Ee - E)/E.
B) R = R + (Ee - E)/E.
C) R = R2 - (Ee - E)/E.
D) R = R /(Ee - E).
E) R = R + (Ee + E)/E.
Answer: B
Page Ref: 512-517
Difficulty: Easy
7) When domestic and foreign currency bonds are imperfect substitutes, the domestic interest
rate (R) can be written as
A) R = R - (Ee - E)/E + ρ.
B) R = R - (Ee - E)/E.
C) R = R + (Ee - E)/E + ρ.
D) R = R - (Ee + E)/E + ρ.
E) R = R - (Ee - E)ρ.
Answer: C
Page Ref: 512-517
Difficulty: Easy
8) In the interest rate parity condition with imperfect substitutes and a risk premium of ρ
A) an increased stock of domestic government debt will raise the difference between the
expected returns on domestic and foreign currency bonds.
B) a decreased stock of domestic government debt will raise the difference between the expected
returns on domestic and foreign currency bonds.
C) an increased stock of domestic government debt will reduce the difference between the
expected returns on domestic and foreign currency bonds.
D) an increased stock of domestic government debt will have no effect on the difference between
the expected returns on domestic and foreign currency bonds.
E) a decreased stock of domestic government debt will have no effect on the difference between
the expected returns on domestic and foreign currency bonds.
Answer: A
Page Ref: 512-517
Difficulty: Easy
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9) The signaling effect of foreign exchange intervention
A) never has any effect on exchange rates.
B) can alter the market's view of exchange rates independent from the stance of monetary and
fiscal policies.
C) cannot cause an immediate exchange rate change when bonds denominated in different
currencies are perfect substitutes.
D) never leads to actual changes in monetary or fiscal policy.
E) can alter the market's view of future monetary policies and cause an immediate exchange rate
change.
Answer: E
Page Ref: 512-517
Difficulty: Easy
10) Please describe in detail a self-fulfilling currency crisis.
Answer: Consider an economy in which domestic commercial banks' liabilities are mainly shortterm deposits, and in which many of the banks' loans to businesses are likely to go unpaid in the
event of a recession. If the market suspects there will be devaluation, interest rates will rise,
banks' borrowing costs go up, and a banks' assets have lower value if a recession hits. To prevent
financial collapse, the central bank will lend money to banks and no longer be able to keep the
exchange rate from rising. Thus, the emergence of devaluation expectations eventually leads to a
devaluation of currency (self-fulfilling).
Page Ref: 512-517
Difficulty: Moderate
11) Describe the effect of the 2008-2009 global financial crisis on the Swiss franc and the central
bank's efforts to respond to the resulting problems.
Answer: The 2008-2009 global financial crisis resulted in appreciation of the franc as currency
traders purchased the franc as a safe haven currency. The Swiss economy consequently suffered
as its products became less competitive with imports. The Swiss responded by committing to
currency intervention designed to control appreciation of the franc and restore the country's
competitiveness in global markets.
Page Ref: 512-517
Difficulty: Moderate
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12) Use a figure to explain how a balance of payments crisis and its hand in capital flight.
Answer:
Suppose the foreign exchange market expects the government to devalue the currency in the
future and adopt a new fixed exchange rate > . This leads to a rightward shift in the curve
that measures the expected domestic currency return on foreign currency deposits. Since the
exchange rate remains fixed at , the domestic interest rate must rise to R* + ( - )/ . The
central bank must sell foreign reserves and shrink the money supply in response. This reserve
loss accompanying a devaluation scare is labeled capital flight.
Page Ref: 512-517
Difficulty: Difficult
18.7 Reserve Currencies in the World Monetary System
1) Briefly describe two systems for fixing the exchange rates of all currencies against each other
and the time periods in which they were used.
Answer: The first is to single cut one country's currency as the reserve currency. The other
countries hold this reserve currency and fix their interest rate to it by standing ready to exchange
domestic currency for the reserve currency. The U.S. dollar was the reserve currency from 1945
to 1973. The second is the gold standard in which central banks peg the prices of their currencies
in terms of gold and hold gold as official international reserves. This was used between 1870 and
1914.
Page Ref: 518-519
Difficulty: Difficult
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2) This question concerns the mechanism of a reserve currency standard.
Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S.
dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the
exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the
mechanism if the x-y exchange rate was 0.5 x per y.
Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the
central bank of X (receiving 300 x), then selling your 300 x to the foreign exchange market for
300 x/(0.5 x per y) = 600 y, then buying U.S. dollars in the amount of $120 from the central bank
of Y. Thus the foreign exchange market will bid the x-y exchange rate up to 0.6 x per y.
Page Ref: 518-519
Difficulty: Difficult
3) This question concerns the mechanism of a reserve currency standard.
Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S.
dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the
exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the
mechanism if the x-y exchange rate was 0.8 x per y.
Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the
central bank of Y (receiving 500 y), then selling this 500 y to the foreign exchange market for
500 y/(0.8 x per y) = 400 x, then buying $133.33 U.S. dollars from the central bank of X with
this 400 x. Thus the foreign exchange market will bid the x-y exchange rate down to 0.6.
Page Ref: 518-519
Difficulty: Difficult
4) Explain how a country whose currency is the reserve currency can use monetary policy for
macroeconomic stabilization. In particular, explain the result if that country doubled its domestic
money supply.
Answer: The immediate result of the doubling of the money supply in the reserve currency's
country will be able to increase the exchange rate between the reserve currency and all other
currencies. However, all other countries must fix their exchange rate to the reserve currency, so
they will purchase the reserve currency and hold it as official international reserves (thus
increase their own money supply) until the exchange rate has returned to normal. Thus, the
reserve country has the power to affect its own economy and all other countries must adjust in
response.
Page Ref: 518-519
Difficulty: Moderate
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18.8 The Gold Standard
1) From 1837 and up until the Civil War, the United States adhered to a
A) gold standard.
B) silver standard.
C) bimetallic standard.
D) bronze standard.
E) copper standard.
Answer: C
Page Ref: 520-526
Difficulty: Easy
2) From the Civil War up to 1914, the United States adhered to a
A) gold standard.
B) silver standard.
C) bimetallic standard.
D) bronze standard.
E) copper standard.
Answer: A
Page Ref: 520-526
Difficulty: Easy
3) Assuming perfect asset substitutability, can sterilized intervention by the central bank be
effective? Please discuss.
Answer: No, a sterilized foreign exchange intervention by the central bank leaves the domestic
money supply unchanged. Under floating exchange rates, a change in the interest rate is needed
to affect the exchange rate, but the interest rate won't change if the money supply does not.
Under a fixed exchange rate, an expansive policy needs to be offset by an increase in the
domestic money supply. To avoid inflation, the central bank sterilizes this increase in the money
supply by selling domestic assets. However, with a fixed exchange rate, this means buying
foreign assets. If foreign assets are perfect substitutes for domestic assets, this sterilization is not
effective.
Page Ref: 520-526
Difficulty: Moderate
4) Does the signalling effect of foreign exchange intervention support or refute the claim that
assets cannot be perfect substitutes if sterilized intervention is going to have any effect? Please
explain.
Answer: The signalling effect refutes the claim. Even with the assumption of perfect asset
substitutability, if the market is unsure of the future direction of policy, then sterilized
intervention can fix a market's expectations about the exchange rate in the future. From post
discussion, a change in the expected exchange rate will lead to a change in the exchange rate
today.
Page Ref: 520-526
Difficulty: Moderate
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5) Briefly discuss the main advantage of the bimetallic standard over the gold standard.
Answer: The advantage of bimetallism was that it might reduce the price level instability
resulting from the use of gold alone. Were gold to become scarce and expensive, cheaper and
relatively abundant silver would become the predominant form of money, thereby mitigating the
deflation that a pure gold standard would imply.
Page Ref: 520-526
Difficulty: Moderate
6) List the drawbacks of the gold standard.
Answer:
1. Undesirable constraints on the use of monetary policy to fight unemployment.
2. A stable overall price level is achieved only if the relative price of gold and all other goods
and services is stable.
3. A central bank cannot increase holdings of international reserves as its economy grows unless
new gold is discovered.
4. Unfair advantage to gold-producing nations.
Page Ref: 520-526
Difficulty: Moderate
7) Describe the mechanism which would take place if the Bank of England decides to increase its
money supply by purchasing domestic assets under the gold standard.
Answer: The increase in Britain's money supply would push interest rates down and make
foreign currency assets more attractive than domestic ones. Holders of pound deposits will
attempt to sell them for foreign deposits. To accomplish this, they sell pound deposits to the
Bank of England for gold and then use this gold to purchase foreign deposits. England loses
foreign reserves since it is selling gold and foreign countries are gaining reserves. Equilibrium is
re-established after Britain's money supply has fallen enough to force the British interest rate up
until it is equally as attractive as the interest rate on foreign currency.
Page Ref: 520-526
Difficulty: Difficult
8) Please briefly describe what is meant by a gold exchange standard.
Answer: Under a gold exchange standard, central banks' reserves consist of gold and currencies
whose price in terms of gold are fixed, and each central bank fixes its exchange rate to a
currency with a fixed gold price. The post-WWII currency system was supposed to be a gold
exchange standard with the U.S. responsible for fixing the price of gold at $35 per ounce.
Page Ref: 520-526
Difficulty: Moderate
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9) Use a figure to show the effect of a sterilized central bank purchase of foreign assets under the
imperfect asset substitutability assumption.
Answer:
The interest parity condition is given by
R = R* + ( - E)/E +
Suppose that the domestic assets of the central bank fall from
to
through a sterilized
purchase of foreign assets. Then the risk-adjusted return increases and the exchange rate
increases.
Page Ref: 520-526
Difficulty: Difficult
10) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates
are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference
between domestic government debt, B, and domestic assets of the central bank, A, i.e.,
ρ=
Find the new domestic interest rate if a sterilized purchase of foreign assets adjusts A s.t.
(a) B - A = -.01/
(b) B - A = .01/
(c) B - A = .03/
Answer: (a) R = .05 + .01 + (-.01) = .05
(b) R = .05 + .01 + (.01) = .07
(c) R = .05 + .01 + (.03) = .09
Page Ref: 520-526
Difficulty: Moderate
26
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11) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates
are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference
between domestic government debt, B, and domestic assets of the central bank, A, i.e.,
ρ=
How much will the central bank have to reduce domestic assets A s.t. the domestic interest rate
will increase by (a) 1% (b) 4%?
Answer: (a) ρ = .01 =
ΔA =
- (B -
)
- (B -
)
(b) ρ = .04 =
ΔA =
Page Ref: 520-526
Difficulty: Moderate
12) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the euro
price of gold is pegged at 12 euro per ounce, what is the dollar/euro exchange rate?
Answer: The dollar/euro exchange rate must be constant and equal to
($35 per ounce) / (12 euro per ounce) = $2.92 per euro.
Page Ref: 520-526
Difficulty: Moderate
13) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the
dollar/euro exchange rate is set at $2.40 per euro, what must the euro price of gold be pegged at?
Answer: The euro price of gold is constant and equal to
($35 per ounce) / ($2.40 per euro) = 14.58 euro per ounce.
Page Ref: 520-526
Difficulty: Moderate
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14) From the figure below, please provide an explanation for the large decline in the growth rate
of international reserves held by developing countries in the 2008-2009 period.
Answer: The growth of global capital markets has increased the potential variability of financial
flaws across borders, and especially across the borders of developing countries. The sharp
decline in developing country reserve growth was due to an international debt crisis from 20072009.
Page Ref: 520-526
Difficulty: Difficult
18.9 Appendix 1 to Chapter 18: Equilibrium in the Foreign Exchange Market
with Imperfect Asset Substitutability
1) If assets are imperfect substitutes, then an increase in the amount of domestic currency bonds
held by the public will ________ the risk premium and ________ the amount of domestic
currency bonds held by the central bank.
A) increase; leave unchanged
B) increase; decrease
C) increase; increase
D) decrease; decrease
E) leave unchanged; decrease
Answer: A
Page Ref: 532-534
Difficulty: Moderate
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2) If assets are imperfect substitutes, then a decrease in the amount of domestic currency bonds
held by the public will ________ the risk premium and ________ the amount of domestic
currency bonds held by the central bank.
A) decrease; leave unchanged
B) increase; decrease
C) increase; increase
D) decrease; decrease
E) leave unchanged; decrease
Answer: A
Page Ref: 532-534
Difficulty: Moderate
18.10 Appendix 2 to Chapter 18: The Timing of Balance of Payments Crises
1) Balance of payments crises under fixed exchange rates occur because of
A) government policies that are inconsistent with fixed exchange rates.
B) punitive currency wars.
C) global inflation and trade imbalances due to war.
D) excessive exports and imports that overload the global system.
E) monotonic expansion in global currency volume.
Answer: A
Page Ref: 535-537
Difficulty: Easy
2) A balance of payments crises under fixed exchange rates occurs when
A) a country runs out of foreign reserves.
B) a country is in a liquidity trap.
C) exports and imports expand beyond some point.
D) marginal returns on foreign exchange investments approach zero.
E) forward currency markets undergo high volatility.
Answer: A
Page Ref: 535-537
Difficulty: Easy
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